How 6 Is Too Many, and 3 Million Is Not Enough: The “Retirement Cap” Myth

The uproar from the financial industry over President Obama’s proposed “retirement cap” is preposterous, but unsurprising. In the usual vein, the industry presents the proposed limit as an attack on the hard worker and diligent saver, despite the fact that it comes nowhere close to affecting even the top 1 percent of earners. In fact, it doesn’t touch the top one-tenth of one percent. For every 10,000 IRA account holders, a whole six accounts would be affected by the limit. That number is even lower for 401(k) accounts. As Fred Hiatt for the Washington Post explained, the employee-benefit lobby quickly mobilized to forestall this outrageous “’socialist idea’ of ‘raiding’ retirement accounts.” And the lobby is succeeding.

Even with little chance of the cap’s passage for the foreseeable future, it’s still worth clarifying a few misconceptions about the proposal so that future discussions about limits on tax-favored retirement savings may not be as burdened with the canards of the present. Despite the hyperbolic doomsday rhetoric of some financial industry opponents, the proposal doesn’t limit retirement savings (and certainly wouldn’t authorize the government to “confiscate” retirement savings); it merely limits the tax benefit available to those who amass millions in tax-favored retirement accounts. This is a crucial distinction.

The original purpose of these tax-favored retirement accounts (IRAs, 410(k)s, 403(b)s) was to provide incentives for workers without employer-sponsored defined-benefit retirement plans (pensions) to save for old age. Understanding that people respond to incentives, the intention was to provide a good reason for people to save for retirement beyond just the government’s telling them that it was the smart thing to do. Workers can defer the income-tax burden of the amount saved from their high-earning years to their retired years, in which they would presumably pay lower taxes in a lower tax bracket.

However, beyond this purpose, the government ceases to have an interest in providing these incentives when they are used to subsidize extravagant levels of wealth through expensive tax windfalls for a very exclusive class of high-income earners. The proposal would not prevent those wealthy enough to afford an annuity that will guarantee them an income of $205,000 per year for life after age 62 from saving for retirement in non-tax deferred accounts. It isn’t suggested that individuals shouldn’t be free to save money for retirement in non-tax-deferred accounts; indeed they would be well served in doing so. The policy question is whether those individuals need publicly subsidized incentives to save for retirement, or if the public’s resources would be better spent encouraging more savings for those with much higher levels of need.

Perhaps the most common misconception about the proposal is that it is variously a $3 or $3.4 million (depending on the news source) gross accrual limit that is not sensitive to inflation. In fact, the limit is not based on a lump sum, but rather on an existing and notably less controversial IRS limit that has been dutifully adjusted for inflation for decades, as statutorily required. Thus, one of the most potent criticisms of the proposal, that it would impoverish today’s youth because of inflationary pressures, is unwarranted. Instead, the proposal would limit retirement savings to whatever amount in the future would permit for the purchasing power of $205,000 per year in today’s dollars.

Another misperception is that it would insulate from the cap those supposedly ultra-entitled government employees who are guaranteed generous pensions, and place the burden on private-sector employees who do not have the security of a defined-benefit plan. The truth is, however, that because the cap essentially limits the allowable annual disbursement amount to retirees, not the lump sum of assets, the value of a worker’s pension is counted against that $205,000 cap. Those fortunate enough to have a pension would face a cap at a lower value, depending on the value of their pensions, than the current $3.4 million. One unlikely political consequence of basing this limit on the existing defined-benefit cap is that the financial services industry may begin to see the raising or eliminating of the heretofore uncontroversial IRS limit on defined-benefit pensions as one of its new legislative priorities. The trajectory of the ever-dwindling number of real guaranteed pensions in the workforce may then begin to change course, not because more average workers are receiving them, but because such a proposal would permit employers to defer massive amounts of compensation for highly-paid employees in the form of tax-favored defined-benefit retirement plans.

While the financial services industry and employee-benefit groups fight for the rights of the “top one-thousandth” to hold as much money as possible in tax-favored savings vehicles, the truth is that this limit, as currently proposed, does almost nothing to address the massive and growing inequities in savings and assets. Even if enacted, the law would still permit individuals to accrue in tax-favored accounts assets that would provide for a $205,000 salary per year in retirement. For the millions of workers who can hardly begin to contemplate the prospect of making that much money in a year, the financial industry’s inordinate attention to multi-million-dollar caps serves little purpose. The effect of the industry’s emphasis on these limits is to divert the retirement security discussion away from the most urgent and widespread problems such as the lack of access to effective retirement savings vehicles for low-income workers. The cap may change the behavior of those 6 individuals in 10,000, but it will do nothing to help the average worker save more for retirement. It’s astounding that controversy is stirred about a proposal that would merely apply the appropriate existing income tax bracket to the income of those earners who are in the condition to consider $205,000 annually to be too little. The rewards of tax-favored wealth for 6 in 10,000 should not be allowed to outweigh the necessity of retirement security for all.

As this debate moves forward, here are some important points to remember about this proposal:

· The limit is not a retirement cap; it is a cap on the amount of tax benefits that can be claimed by an individual through the use of retirement accounts

· The limit is based on the cost of an annuity in that year; not on a gross amount

· (Technically, the limit is based on the actuarial equivalent of the cost of an annuity at age 62 worth the same amount as the IRS’s allowable maximum value of a defined benefit retirement plan purchased in that year)

· The IRS’s limit on the value of pensions is adjusted for inflation, which means the limit on tax-favored retirement savings would also be adjusted for inflation

· The total amount held by an individual in all IRAs, 401(k)s, and pensions would be aggregated, then counted against the current limit

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